Walter Doggett, VP Taxes, E*Trade
Tom Cullinan, Partner, Sutherland
Joe DePew, Partner, Sutherland
Defending Taxpayer Penalties Audit, Appeals and Litigation
Considerations
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©2008 Sutherland
Accuracy-Related Penalties Section 6662
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Negligence and disregard of rules or regulations (20%)
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Substantial understatement (20%)
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Substantial valuation misstatements (20%)
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Gross valuation misstatements (40%)
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Transactions lacking economic substance (20%) (for transactions
entered into after 3/30/10)
 40% if not disclosed
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2
Undisclosed foreign financial asset (40%) (for tax years beginning
after 3/18/10)
©2008 Sutherland
Accuracy-Related Penalties Section 6662A
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Only for LTs/RTs
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If not disclosed: 30%
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If disclosed: 20%
 Section 6664(d) reasonable cause exception may be available
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Effective date: tax years ending after 10/22/04
©2008 Sutherland
Penalty on Refund Claims
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Claim for refund or credit in “excessive amount”
 “Excessive amount” is the amount by which the claim for refund or credit for
the tax year exceeds the amount of refund or credit allowable for the tax year
 No de minimus exception – would seem to apply to any and all claims
 Guidance under consideration
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Penalty equals 20% of the amount
Reasonable cause exception
Ordering rule to coordinate with IRC §§ 6662, 6662A and 6663
Effective for claims filed or submitted after May 25, 2007
©2008 Sutherland
Policy
Larry Langdon memo to LMSB
(December 20, 2001)
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“Examiners must consider the accuracy-related penalty under Section
6662 for underpayments attributable to a taxpayer’s participation in a
listed transaction.”
Commissioner Everson Memo to LMSB and SBSE
(December 29, 2003)
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5
“The Service will not accept reliance on an opinion from a nonindependent tax advisor as proof of reasonable cause and good faith on
the part of the taxpayer.”
©2008 Sutherland
Policy
Dave Robison Memo to Appeals
(June 21, 2004)
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6
“The purpose of this memorandum is to establish a new policy for
Appeals concerning the settlement of penalty issues. Effective
immediately, we will no longer trade penalty issues in Appeals.
Penalties can and should still be settled, but the settlement should
be based on the merits and the hazards surrounding each penalty
issue standing alone.”
©2008 Sutherland
Policy
Chief Counsel Notice 2004-036
(September 22, 2004)
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“It is important that all Service functions coordinate the application of
penalties so that:
 Examination employees consider, develop, and impose penalties where
appropriate, with heightened scrutiny given to cases involving a listed
transaction or a transaction that the Service has otherwise identified as
potentially abusive;
 Appeals and Counsel resolve penalties based on their merits, including a
hazards assessment and, finally,
 Counsel defends the penalty determination in litigation based on an analysis
of the hazards of litigation for the penalty independent of the hazards of
litigation for the underlying tax adjustments.”
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©2008 Sutherland
Policy
IRS Policy Statement 20-1
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8
“In order to effectively use penalties to encourage compliant
conduct, examiners and their managers must consider the
applicability of penalties in each case, and fully develop the
penalty issue when the initial consideration indicates that
penalties should apply. That is, examiners and their managers
must consider the elements of each potentially applicable penalty
and then fully develop the facts to support the application of the
penalty, or to establish that the penalty does not apply, when the
initial consideration indicates that penalties should apply. Full
development of the penalty issue is important for Appeals to
sustain a penalty and for Counsel to successfully defend that
penalty in litigation.”
©2008 Sutherland
Implications of IRS Policy
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Exam teams have less discretion
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Emphasis on development
 E.g., IDRs targeted at penalties
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More penalties are raised in RARs
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It may be harder to trade penalties at appeals
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More litigation
©2008 Sutherland
Defenses to Negligence and
Disregard Penalties
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Negligence – reasonable basis
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Disregarding rules or regulations –
1.
Adequate disclosure (and compliance with reportable transaction
rules, if applicable)
 position contrary to regulation must also be good faith challenge
to validity
2.
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10
Penalty does not apply to position contrary to revenue ruling or
notice if it has a realistic possibility of being sustained on the merits
(except for reportable transactions)
All – reasonable cause under Section 6664 (plus adequate
disclosure for position contrary to a regulation)
©2008 Sutherland
Defenses to
Substantial Understatement Penalty
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Substantial Authority
 Objective inquiry
 Taxpayer has burden of proving substantial authority
 “Authority” is defined by Treas. Reg. Section 1.6662-4(d)(3)(iii)
 Authority inquiry made at the time return was filed
 Defense not applicable to tax shelters
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Adequate Disclosure and Reasonable Basis
 Form 8275 and Form 8275-R
 Rev. Proc. 2006-48
 Defense not applicable to tax shelters
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Reasonable Cause under Section 6664
©2008 Sutherland
Defenses to Valuation Misstatements, Economic
Substance and Undisclosed Foreign Financial
Assets
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Valuation misstatements – reasonable cause and good
faith exception
 “attributable to” – United States v. Woods, 134 S. Ct. 557 (2013)
 Special rule for charitable deduction property
 must have qualified appraisal made by Qualified Appraiser
 Special rule for net Section 482 transfer price adjustment
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Economic substance penalty – reasonable cause is not
available
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Foreign financial assets – reasonable cause and good
faith exception
©2008 Sutherland
Reasonable Cause and Good Faith
Defense (Section 6664(c))
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Facts and circumstances test
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Reliance on opinion or advice
 Advisor must be qualified
 Advice must be based on pertinent facts and circumstances
 No unreasonable assumptions
 Disclosure required where position is contrary to regulation
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Failure to disclose RT is a “strong indication” taxpayer did not act in good
faith
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Special rules for corporate tax shelters
 Must have substantial authority and
 More likely than not belief
 Those are only minimum requirements, not dispositive
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©2008 Sutherland
Reasonable Cause for Reportable
Transactions (Section 6664(d))
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Protects against Section 6662A penalty for LTs and
RTs, provided (not if lack ES)
 Adequate disclosure of relevant facts affecting asserted tax
treatment
 Substantial authority for such treatment; and
 Reasonable belief that such treatment MLTN correct
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Can’t rely on outside MLTN opinion if
 Disqualified opinion (“DTO”) or
 Disqualified tax advisor (“DTA”)
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©2008 Sutherland
Disqualified Opinion
(Section 6664(d)(3)(B)(iii))
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Based on unreasonable factual or legal assumptions
(including as to future events);
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Unreasonably relies upon representations, statements,
findings or agreements of the taxpayer or any other
person;
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Fails to identify and consider all relevant facts; or
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Fails to meet any other opinion-related requirements
prescribed by Treasury (i.e., Circular 230 standards)
©2008 Sutherland
Disqualified Tax Advisor
(Section 6664(d)(3)(B)(ii))
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A DTA is any tax advisor who
 Is a MA and participates in organization, management, promotion or sale of
transaction;
 Is compensated directly or indirectly by a MA;
 Has a fee contingent on asserted tax benefits of transaction; or
 Has a “disqualifying financial interest” in the transaction
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MA services in addition to giving tax opinion will generally trigger DTA
status
 Clearly so if MA firm structures and/or documents transaction
 Even if retained only for tax work, tax advisor can’t suggest “material”
modifications to structure or mechanics of transaction designed to assist
taxpayer in achieving desired tax treatment [Notice 2005-12]
 Unreasonable limitation: may force client to retain separate counsel for tax
planning and tax opinion work in order to assure penalty protection
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©2008 Sutherland
Convincing the Audit Team
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History of compliance and cooperation
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Nature of underlying transaction
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Disclosure on return
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Reliance on advisors
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Written tax opinion
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Elevate the discussion or broaden the audience
©2008 Sutherland
Recent Developments with IDRs
and Reasonable Cause
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Recent Examination IDRs from LB&I for
penalty consideration asking for a statement
that addresses reasonable cause for the
assertion or non-assertion of the Section 6662
penalties for negligence or substantial
understatement
©2008 Sutherland
Appeals and Penalties
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Impact of Appeals’ new AJAC Approach
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Appeals’ discretion may depend on the underlying adjustment
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Penalties no longer subject to “trading”
 Penalties must be evaluated on their own merit
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New Issue guidance and penalties
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Limited flexibility for Appeals Coordinated Issues, Emerging
Issues, and Compliance Coordinated Issues
 Ascertain whether written (or unwritten) penalty guidelines exist
 Settlement possibilities may be limited
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©2008 Sutherland
Privilege Issue in the Penalty
Context
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AU Section 9326.22
Subject Matter Waiver
 FIN 48; United States v. Wells Fargo & Co., 2013 U.S. Dist.
LEXIS 79814 (D. Minn. 2013)
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20
AD Investment 2000 Fund v. Comm’r., 142 T.C. No. 13
(April 16, 2014)
©2008 Sutherland
In the Courts
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“When an accountant or attorney advises a taxpayer
on a matter of tax law, such as whether a liability
exists, it is reasonable for the taxpayer to rely on that
advice. Most taxpayers are not competent to discern
error in the substantive advice of an accountant or
attorney. To require the taxpayer to challenge the
attorney, to seek a “second opinion,” or to try to
monitor counsel on the provisions of the Code himself
would nullify the very purpose of seeking the advice of
a presumed expert in the first place.” United States v.
Boyle, 469 U.S. 241 (1985)
©2008 Sutherland
Considerations for Litigation
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Choice of forum
 Jurisdictional issues
 Precedent
 Discovery procedures
 Time and cost
 Settlement
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Privilege waiver
 Bifurcate penalties from the merits?
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©2008 Sutherland
Considerations for Litigation (contd.)
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Will the advisor stand up?
 Concern about OPR, penalties, malpractice
 Fifth Amendment issues
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Use of experts
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Choice of counsel
©2008 Sutherland
Recent Cases
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United States v. Woods, 134 S. Ct. 557 (2013)
Romanowski v. Comm’r, T.C. Memo 2013-55
Bemont Inv., LLC v. United States, 679 F.3d 339 (5th
Cir. 2012)
106 Ltd. v. Comm’r , 684 F.3d 84 (DC Cir. 2012) aff’g
136 T.C. 67 (2011)
Canal Corp. v. Comm’r, 135 T.C. 199 (2010)
Salem Financial Inc. v. United States, 112 Fed. Cl. 543
(2013)
Rawls Trading LP v. Commissioner, T.C. Memo 2012340
©2008 Sutherland
Special TEFRA Provisions
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Penalties and some penalty defenses must be raised
in the entity-level proceeding
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“Partner-level defenses” can only be asserted in a
subsequent refund action
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United States v. Woods, 134 S. Ct. 557 (2013)
©2008 Sutherland
Practical Considerations
Approach Penalties as a Separate Issue
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Anticipate IRS arguments
 Result is too good to be true
 Advisor did not have all the facts (or the facts were inaccurate)
 Advisor is not independent
 The advice was untimely
 Cookie-cutter opinions
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Consider advantages to briefing Exam separately on penalties
 Memorandum part of administrative file – may help at Appeals
 Opportunity to assess flexibility or lack thereof in asserting penalties
with respect to proposed adjustment
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©2008 Sutherland
Practical Consideration
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Get a written opinion
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Don’t bury the transaction, and perhaps disclose it
From a qualified tax advisor
Who is independent
Who does not assume away critical facts
Give the advisor all of the relevant facts
Get the opinion before you file the return
Make sure the opinion addresses the issues and applies relevant
law
Pay the advisor by the hour
Do not mark opinion “privileged”
©2008 Sutherland